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Skyrocketing App Sales Are a Game Changer for Apple

Apple, Inc.'s biggest growth business is flying way under the radar.

Every three months, in the run-up to Apple's (NASDAQ:AAPL) quarterly earnings report, the rumor mill starts to buzz with guesses about how many iPhones and iPads it was able to sell. The laser-focus on iPhone and iPad sales is very understandable. In its 2013 fiscal year, Apple derived 53% of its revenue from the iPhone product line and another 19% from the iPad.

There's another reason why pundits zero in on iPhone and iPad sales -- they're easy to see. Anyone can stand outside the Apple Store and see how busy it is and how many people walk out with new iProducts.

It's easy to observe foot traffic at the Apple Store, but harder to observe app sales in real time.

The growing adoption of iPhones and iPads has led to skyrocketing sales of apps -- and, to a lesser extent, media -- through the iTunes Store. While these electronic purchases are harder to observe, they represent a game changer for Apple. Rising app and media sales will make Apple's business less seasonal, and they will mitigate the long-term threat of pricing pressure.

App sales keep flying higherIn the last year and a half, Apple has come under scrutiny from investors due to an abrupt slowdown in growth for the iPhone and iPad product lines. In its most recent fiscal year, iPhone revenue growth plummeted from 71% to 16%, while iPad revenue growth fell from 61% to just 3%.

Last quarter, iPad revenue growth rebounded slightly to 7%, on the back of new products like the iPad Air, as well as price cuts for the first-generation iPad Mini. By contrast, iPhone revenue growth slowed further, to 6%.

However, while sales growth has stalled out for Apple's hardware, iOS users are buying more and more stuff through iTunes -- whether it be apps, music, movies, or books. Last year, Apple reported revenue growth of 25% in the "iTunes, software, and services" product line, making it the fastest-growing piece of Apple's business. Revenue of $16 billion represented nearly 10% of the companywide total.

iTunes and the App Store are becoming big business.

Last quarter, iTunes, software, and services growth subsided to a still-healthy 19% rate -- slightly down from 22% growth in the prior-year quarter. This was enough to maintain its position as the fastest-growing piece of Apple's business.

Two big changesBased on its recent growth trajectory, the iTunes, software, and services business will represent more than 10% of Apple's revenue this year for the first time ever. The growth of app-related revenue will gradually transform Apple's business in two key ways.

First, whereas product sales are highly seasonal, peaking in the holiday quarter, app revenue is more constant throughout the year. If anything, the seasonality of app sales runs slightly counter to the seasonality of device sales. Last year, sequential growth for the iTunes, software, and services business peaked in the March quarter -- when revenue was falling for every other product line.

All things considered, this is good for Apple, because it will lead to more stable financial results. Eventually -- although this could take many years to play out -- the increasing importance of app and media revenue compared to device revenue could reduce the volatility of Apple stock, which is very sensitive today to rumors about iPhone and iPad sales.

Second, the growth of app and media revenue will gradually insulate Apple from the risk of pricing pressure in the device business. Many Apple investors fear that as cheaper phones and tablets become "good enough," Apple could be forced to cut prices to ensure that its customers stick around. Additionally, even loyal iPhone users could upgrade less frequently if Apple can't provide significant improvements for each new phone.

Pricing pressure has already had a noticeable impact on the iPad product line. Revenue growth has dropped precipitously to the single digits as lower average selling prices offset continued unit sales increases. The same thing could happen to the iPhone eventually. However, Apple could live with lower margins on product sales if device users are providing a reliable, growing stream of app and media revenue.

Foolish final thoughtsFor the last few years, the iPhone and iPad have been front and center in the minds of Apple investors. Other devices like the Mac and iPod have received much less attention, and non-device businesses like iTunes and the App Store have been way on the back burner.

However, the iTunes, software, and services line now represents about 10% of Apple's revenue, and is the fastest growing part of Apple's business. As it continues growing in the next few years, it could transform Apple's overall business in two positive ways -- reducing its seasonality and mitigating the company's reliance on high-priced device sales. Investors should welcome this change.

Author

Adam Levine-Weinberg is a senior Industrials/Consumer Goods specialist with The Motley Fool. He is an avid stock-market watcher and a value investor at heart. He primarily covers airline, auto, retail, and tech stocks. Follow him on Twitter for the latest news and commentary on the airline industry! Follow @AdamLLW